McMurtry Investment Report Newsletter – January 2021

Last year when the pandemic first started rearing its ugly head, equity markets globally collapsed. During this period of very weak economic growth, certain sectors outperformed the overall market and other sectors sharply underperformed. This market reaction was quite normal under the circumstances.

Consumer staples stocks did much better than the market benchmarks. Companies like Clorox, the maker of sanitized wipes that could effectively remove Covid-19 bacteria from surfaces, performed extremely well. The shares of grocery chains also did very well over the same period. Other groups that outperformed were electronic gaming companies with the vast majority of the workforce working from home in the midst of all the mandated lockdowns. Other consumer discretionary stocks like Home Depot and Lowes benefitted from the consumers’ focus on home renovation. High tech companies such as Microsoft and Zoom saw their earnings climb sharply as a result of the sharp increase in online video conferencing.

The health care industry was a stellar performer with the combination of new vaccines produced by Pfizer and Moderna and companies like Abbott Labs and Perkin Elmer providing an assortment of diagnostic tests to determine the presence of Covid- 19.

Groups that were initially the hardest hit were hotels, restaurants, airlines, cruise lines, movie theatres and any other industries affected by travel. The retail sector was also severely negatively affected, but the big box stores like Target, Costco and Wal-Mart fared much better than the smaller companies.

However, as soon as the drug companies announced new vaccines with a very high degree of efficacy, there was a massive equity sector rotation into the groups most severely affected by the pandemic. These groups mentioned above included airlines, cruise ships, hotels, restaurants and movie theatres. The equity sector rotation into these oversold groups has been ebbing and flowing depending on the extent of the lockdowns spurred on by a spiking of the number of daily cases and hospitalizations.

Cyclical industries include Financials, Industrials, Materials, Energy, Retailers and Other Consumer Discretionary ones. This most recent market rotation is out of both defensive and high- tech sectors into cyclical ones.

Historically the REIT sector tends to be interest sensitive, not cyclical. However, the virtual closure of the economy initially at the beginning of this pandemic caused profitability in the REIT sector to be severely affected with the inability of both individuals and business owners to pay their rent. Consequently, the REIT sector has become much more cyclical although it is still interest sensitive as well.

The cyclical sectors of the market are now benefitting by the expected improvement in economic activity commencing in the second half of this year. The continued easy monetary policy globally ensures that interest rates will not move up too quickly. The recent gradual pickup in 10- year US treasury yields should not stop the economic recovery from taking hold. In addition, the Democratic victory in both the House of Representatives and the Senate will greatly help to make sure that additional economic stimulus to the battered US economy will be implemented shortly once Joe Biden takes office. Continued weakness in the US dollar globally in addition to a pickup in economic activity in Europe and China will help commodity prices.

Analyzing cyclical companies whose earnings go in and out of profitability is not an easy task. It is important not to simply look at PE multiples when choosing candidates for purchase. A better measure is EBITDA – a form of cash flow that most cyclical industries use extensively. It represents Earnings before interest, taxes, depreciation and amortization expenses. When reviewing cyclical stocks I look at the following ratios:

Enterprise Value / EBITDA – Projected (not trailing twelve months)
Free Cash flow yield
Financial Debt to EBITDA- trailing twelve months
EBITDA Growth – next few years
Cash Flow price leverage from improving commodity prices.

Enterprise Value refers to a company’s market capitalization of both its equity and debt. Ycharts definition of Financial Debt is Long term debt plus current portion of long term debt plus dividends and notes payable.